The Quantum View

Second Quarter 2010

Around the World in 90 Days

By Mat Johnson

Catastrophic oil spills, a Greek bailout, a debt-riddled Europe, Chinese currency revaluation and landmark U.S. bank reform — there have clearly been plenty of reasons for investor concern during the past quarter. In the past ninety days, each of the above events have raised investor concerns and consequently lowered their affinity toward the stock market. While many would be hard pressed to single out the primary direct impact any one of these events will have, the sheer number of events at once has clearly led investors to fear the worst for all companies.

Since the end of March, the U.S. stock market, as measured by the S&P 500, fell more than 12%. Even more pronounced is the 15% decline since late April, coinciding with the massive oil spill in the Gulf of Mexico, and coming just as Greek government debt was downgraded to 'junk' status. Spain's debt was subsequently downgraded, raising fears of 'debt contagion' across Europe and promptly sent the Euro to multi-year lows as questions arose about its long-term viability.

As if these weren't enough issues for investors to digest, the Chinese government made a weekend announcement that it would begin allowing their currency to fluctuate with market forces. While the news was initially well received, the longer its effects were pondered, heightened uncertainty was quickly reflected across global stock markets as no one seemed to be sure which direction those market forces would take it.

Finally, there was financial regulatory reform being hotly debated in the U.S., with the uncertain outcome of which financial industries and companies would see their operations disrupted and which would escape relatively unscathed.

Markets loathe uncertainty, and during the past ninety days the markets were simply pummeled by just about all the fear, uncertainty and doubt that most investors could tolerate. All combined, these events triggered fear of an economic relapse into recession in the U.S., but also raised doubts of there being a strong enough region on the globe to support an eventual global economic recovery.

Warren Buffet once famously noted that, "It's only when the tide goes out that you learn who's been swimming naked." We think an equally apropos analogy today might be, it's only when the tide rises, that it becomes clear who can't swim. We say this because there actually has been a vast improvement in economic conditions from a year ago, though what we've been witnessing in recent weeks is that there is a far larger chasm between those who have learned to adapt to the new economic realities and those who have not.

Unfortunately in the hands of the media, there is a clear bias toward emphasizing the sensational negatives that are in sync with the market's direction. The key to successful investing however, is to separate out the opinion that corresponds with market direction — and merely sounds smart at the time — from what is actually backward looking and largely discounted in the market.

Here in the U.S., we'll admit company sales aren't booming, unless the product's name begins with an "i" and has a cute little half-bitten apple etched on it. Compared to one year ago, however, there has been a not insignificant improvement in general business conditions.

Twelve months back in time, job losses were mounting at a pace of 6.6 million a year, compared to an annual rate of 150,000 now; sales at businesses were declining 12% annually, versus the current rise of more than 5%. Thanks to an incredibly lean level of inventories throughout the economy, U.S. production activity is rising at a healthy clip of 7.6% this year to meet this rise in sales, as opposed to falling more than 13% a year ago as companies aggressively gutted their warehouses.

Where the increase in business sales and production has shown up most dramatically, is in the growth of U.S. company profitability and growth in profits. In fact, if all goes as anticipated this upcoming earnings season, U.S. corporate profitability will remain at, or even surpass, its recent all-time record high of 11.2%, up from 8.7% a year ago, while earnings growth will surpass 40% over the past 12-months, in contrast to a 19% decline in the second quarter of 2009.

While a great deal of this anticipated profit growth owes to sizeable cost reductions over the preceding 12-months, they have also been doing an incredible job of producing and selling precisely, and virtually only, what customers want. This is evidenced by the continued shrinkage of total business inventories — a clear sign of business efficiency and the reason clearance sales are currently so rare to come by.

Clearly, the market's recent volatility suggests that little weight is being given to the rising fundamentals of Corporate America, though at some point, a developing "wall of worry" becomes another investor's opportunity. Viewing the stock market as a gauge for future economic prospects, as conventional wisdom suggests, the recent erratic market action on top of the market declining back to levels last seen nine months ago, suggests far more credence is being given to the fears of a double-dip, than the evidence of increased company health.

The end result of higher earnings and increased investor trepidation has been a continued decline in market valuation, with the price-to-earnings multiple for the broader market falling to just 12x. Expected growth for this year has actually moved marginally higher, effectively resulting in a steeper slope to the "wall of worry" for the market to climb.

What has yet to materialize however, is a catalyst to generate investor conviction to capitalize on the divergence between valuation and growth. The focus of the moment however is on all the factors that could go wrong. As true investors, meaning in companies as opposed to mere stocks, we tend to focus on the businesses that we investors are actually acquiring ownership in.

Accordingly, what has grabbed our attention, despite the pall of dismal news around the globe, is the recent uptick in business activity and investment. This, above all else, is a point of true encouragement as, at the end of the day, what ultimately drives earnings and labor market prospects is how much businesses can and do produce.

In our view, the current backdrop of solid earnings gains and falling valuation has further re-tilted the risk-reward of the market toward a higher risk of not being invested for growth.

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By Brett Meyer, CFA

From March 2009 through April 2010, the US Stock Market as measured by the S&P 500 experienced a rapid ascent from a nadir of 683 to a high of 1217. During this breathtaking 78% rally, it was easy for investors to once again lose sight of the fact that the US Stock Market has historically lost value in nearly half of all the months (45%) during the past sixty years. May and June of 2010 brought this reality into sharp focus with the S&P 500 losing over 13% in these two months. Unfortunately, a simple 13% gain will not bring investors back to even. Rather, investors need a 15%+ gain to get back to even. The following table illustrates the slippery slope increasing magnitudes of losses have on the required return to break even.

Loss Percentage Gain
Percentage Required
-10% 11%
-20% 25%
-30% 43%
-40% 67%
-50% 100%
-60% 150%
-70% 233%
-80% 400%
-90% 900%

Despite these sobering statistics, investors seeking to grow their capital over the long-run shouldn't hide in a cave with cash and T-Bills. Rather, one must intelligently construct an overall portfolio allocation that provides some down market protection with adequate up market participation. However, without a guide for what the appropriate trade-off is between down market protection and up market capture, investors are effectively flying blind.

Quantum Capital Management conducted an internal research project on the S&P 500 over the past 60 years (1950-2010). The goal of the research was to identify the required monthly up market capture ratio to match the S&P 500 return based on a variety of down market capture ratios. The up market capture ratio is expressed as a percentage relative to the S&P 500. For example, a 50% up market capture means that for every 1% gain in the S&P 500, the investor gains 0.5%. Alternatively, a 50% down market capture indicates an investor loss of 0.5% for every 1% loss in the S&P 500. A graphical illustration of the results of the study follows:

This chart highlights the concept of winning by not losing. Investors that manage to protect capital during down market periods require smaller up market captures to keep pace with the S&P 500. A risk managed approach to investing cuts out the extreme peaks and valleys associated with pure equity mandates.

Quantum Capital Management provides an investment product that relates to this downside risk management approach called Quantum Principal Safety (QPS). QPS is a transparent hedged equity portfolio that starts with a select group of Large Cap securities. Portfolio insurance is implemented through the purchase and sale of S&P 500 Index based options. During significant market declines, this insurance component of QPS rises in value to help offset a portion of losses in the underlying stocks. We invite you to learn more about this strategy on our website (www.quantumcap.com) or by contacting us directly to see how QPS might be a useful addition to your overall portfolio allocation. In the words of Warren Buffett, "The first rule in investing, don't lose money".

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By Mike Vogel, CFP®, CFA

California entered the 2010-11 fiscal year without a state budget in place, the 19th time in the last 25 years this has occurred. But does it matter to bondholders?

As with any investment decision, this depends on your individual situation. Yield is the price markets put on risk, whether on price volatility or outright default. Yields generally rise when concerns are highest, and also fluctuate based on supply and demand. The risk in munis comes primarily from volatility in price before maturity, and relative "margin of safety," as opposed to outright risk of default.

For buy-and-hold investors, your primary concern is that interest payments continue to be paid on your bonds and that your principal will be repaid in full at maturity. Because you're holding for the long term, you can accept short-term price volatility.

Regarding bond ratings, as we know from recent high-profile events in corporate credit markets, they're slow to react and are not a guarantee of long-term credit quality or fluctuations in bond price. It is recommended you use them as part, but not all, of an investment decision.

It does not make sense under any circumstances to put all of your eggs in one basket particularly if you are concerned about a dramatic and unforeseen "black swan" event or the spillover effects of budget problems. While protections remain strong, wise investors will focus on the strongest issuers. Here is a guideline for different types of muni bonds and issuers.

GO Bonds are considered the strongest broadest security pledges available for municipalities. They include the "full faith and credit" pledge of the issuer, from any legally available sources. This includes, in many cases, a voter-authorized property tax used only to pay back bonds.

In the event of bankruptcy-possible for local municipalities under Chapter 9 of the bankruptcy code-bond payments can be interrupted by a bankruptcy court. However, these events are so uncommon that legal precedent is unsettled. In at least a few of the recent cases, troubled municipalities have continued to make bond payments, even in bankruptcy.

Lease Revenue Bonds are secured by state leases on a variety of state properties and facilities. Their payment comes after both education expenditures and payments on GO bonds, and at the same time (according to bond documents) as state employee wages, contributions to the state pension funds and state Medi-Cal health care claims. They carry lower bond ratings and are less secure than state GO bonds.

Economic Recovery Bonds are secured by a dedicated state sales tax, with back-up support from the state general fund. They rely on the strength of sales tax collections, coverage on debt payments provided by those taxes, and other legal protections. The rating on these was downgraded recently as well, however, due to declining sales tax collections.

California State Public Works and other types of state infrastructure bonds or financing authorities can vary, but are generally secured by a mix of state or state-department leases on buildings or other revenues. These are not always direct obligations of the state general fund, so funding sources can vary. It's helpful to read a prospectus for the bonds to understand if there may be unique risks involved.

City GOs Cities in most states rely to a degree on state support, but less so than most other local jurisdictions. They have greater revenue-raising ability at the local level through fees and other charges, and fewer state-required and state-funded service obligations.

However, they're vulnerable to "take-aways" of local revenues by the state. A remedy pursued in the past and in the current budget to help with state-level problems. But, they generally have more tools to adjust than other local municipalities.

Their local economies and service needs, however, vary more widely. The weakest and most economically compromised do face significant budget stresses. These include declining local property and sales tax revenues, as well as rising (and contractually guaranteed) costs.

Due diligence is required here; try to limit exposure to any single issuer. The highest-rated and most-affluent cities will generally be in better position to meet bond-payment obligations.

County Gos Counties in California face the stiff headwinds of a slew of mandated services-such as indigent health care, social services and other expensive service obligations-that are not well-funded, but still legally required. They rely heavily on state funding to provide these services and have less revenue-raising ability than California cities.

Counties also have a more difficult time securing voter support for GO bonds or tax increases due to their larger jurisdictions and less-popular service obligations. As a result, they're often issuers of "lease-revenue" bonds, also called "certificates of participation," or COPS. We'll discuss those below.

While they're less frequent issuers of GO bonds, counties are heavily exposed to the crunch of service pressures and budget cuts. They generally adjust with service cuts, but different counties will vary in their flexibility and response.

Lease-Revenue Bonds (also known as Certificates of Participation, or COPs) School districts, Cities and Counties can also issue lease revenue bonds to fund infrastructure needs. COPs are secured by a municipality's pledge to make lease payments for use of various government properties. The leases are renewed annually, at the municipality's discretion. If the leases are not renewed, a trustee must repossess the property and either re-lease or sell for the benefit of bondholders.

Municipalities issue COPs to maneuver around state constitutional requirements that require a local vote for any long-term bond obligation that spans more than a single fiscal year; the renewable lease provision allows them to get around this restriction. COPs are also not secured by a local property tax collected solely for the purpose of making bond payments.

Ratings are lower than those on GO bonds, but defaults or non-renewal of leases are equally rare. Still, during periods of severe budget stress, consider these to be less-protected and more at risk, compared to local GO bonds.

Essential Service Revenue Bonds These include water or sewer service revenue bonds, secured by local fees for water, sewer (or other) essential services. These issuers are typically less reliant on state revenues and budgets to support bond payments. The more essential the service, generally, the more predictable revenues are likely to be to support bond payments.

Water/sewer and other essential-service revenue bonds are relatively secure investments and a good way to diversify away from more state-sensitive muni bonds.

Other Tax-Exempt Revenue Bonds These types of revenue bonds are secured by revenues from a particular public enterprise, like a hospital, airport or university. Along with water and sewer revenue bonds, they make up roughly half of the total investment-grade muni bond market. The protections will vary, as well as the reliance on state revenue support to provide those services, if any. They're also more frequently exposed to local business risks.

Tax Allocation Bonds (TABs), Community Facilities Districts (CFDs) These bonds are generally secured by local property assessments, levied either on a per-parcel basis or as a percent of the assessed. These securities can be quite complex, and liquidity/market demand can vary. Also, one of the "fixes" in California's budget has been a "take-away" of revenues from many redevelopment tax allocation districts, which could impact revenues available to pay on TABs.

Politics is the wildcard that complicates discussion with munis. Even with all the politics, there have been no discussions by state officials about default on state general obligation bonds. Still, yields on California bonds are higher than other states for a reason. The obstacles don't end today, nor will news of cuts, lawsuits and other challenges. If you do choose to invest in individual-issuer munis, higher yields may be the indicator of higher volatility in value, if you need to sell before maturity. If this drop in value is something you can stomach, it makes sense to hold California bonds and other more "news-sensitive" bonds as part of your fixed income portfolio.

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By Stephen Bradley

Our principal role is, in partnership with our clients, to provide the investment discipline and ongoing counsel to our clients in order to help them attain their specific objectives.

Most investors view investing too simply, resulting in a large discrepancy between the long term returns capital markets provide and what most investors actually realize. This is true not only of individuals, but a large swath of the professional investment community as well.

Why does this happen? Many investors view investing naively, lack defined investment objectives, and focus on their investments infrequently, and often at precisely the wrong times.

During "normal" times, "investing" is regarded as something most anybody can do reasonably well through conventional processes such as simple asset allocation, indexing (both "return taking") or choosing a basket of "blue chips." Unfortunately, this still amounts to speculation.

Many conventional managers fail because they tend to overlook fact-based fundamentals in favor of attractive, colorful stories. Still others fail because they don't invest in a deep understanding of how the capital markets work, instead relying upon trying to out-guess what the general investing public might do based on price movements, or technical analysis.

During periods of market uncertainty, investor anxiety leads many investors to do precisely the wrong thing, at the wrong time - the by-product of not knowing what the fundamental value of their investments are. In the process, their ultimate objectives become lost.

Successful investing is a full-time endeavor. It takes a deep understanding of how the capital markets price assets, as well as an appreciation for when emotions lead to sizable deviations (risks and opportunities) from the underlying fundamentals. Our investment philosophy is based on time-tested fundamental analysis that is devoid of emotional decision-making.

Our ultimate objective is to help our clients leverage what we do successfully to meet their unique objectives.

The following tables illustrate common mistakes by most individual investors.







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